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The Middle Class Faces Extinction—So Does the American Dream

Income inequality is now as high as it's been since the Great Depression, and the middle class is nearly extinct.

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It was a theory that gained traction during the global economic crisis of the 1970s and with the publication in 1975 of a highly influential book, Equality and Efficiency: The Big Tradeoff, by the late American mainstream economist Arthur Okun. This theory — that you can have either more equal societies or more economically successful ones, but not both — has been used to justify the growth of inequality in the United States, a trend that has since spread to a majority of the rich world. One of the telling by-products of the current economic crisis is that this theory is now being challenged. It is now being increasingly argued that the levels of income concentration in recent times have had a significant negative effect on the economy, bringing slower growth and greater turbulence and contributing to both the 2008 crash and the lack of a sustained recovery.

Perhaps the most significant convert to these ideas is President Obama. A year ago, he remarked, “When middle-class families can no longer afford to buy the goods and services that businesses are selling, it drags down the entire economy from top to bottom.” Addressing delegates at the annual meeting of the World Economic Forum at Davos in January 2013, Christine Lagarde, head of the International Monetary Fund, endorsed this view, “I believe that the economics profession and the policy community have downplayed inequality for too long […] [A] more equal distribution of income allows for more economic stability, more sustained economic growth.”

This view goes against the grain of the economic orthodoxy of the last 30 years. As the Chicago economist Robert E. Lucas, Nobel prizewinner and one of the principal architects of the pro-market, self-regulating school that has dominated economic strategy in the Anglo-Saxon world, declared in 2003, “Of the tendencies that are harmful to sound economics, the most poisonous is to focus on questions of distribution.”

A growing body of evidence and opinion now holds that this idea is wrong. In fact, the “distribution question” — how the cake is divided, between wages and profits on the one hand, and between the top and bottom on the other — is critical to economic health. Over the last 30 years, the rich world, led by the United States, has steered a growing share of national output first to profits and ultimately to the top one percent. Across the 34 richest nations in the world, the share going to wages has fallen from over 66 percent in 1990 to less than 62 percent today. The result is a growing detachment of living standards from output. The stagnating incomes of the bulk of Americans, along with the shrinking of the middle, are the mirror image of the rise of the plutocracy and the return of the gilded age.

This decoupling of wages from output creates a critical structural fault that ultimately brings self-destruction. First, a growing pay-output gap sucks consumer lifeblood out of economies. To fill this growing demand gap, levels of personal debt were allowed to explode. In the US, the level of outstanding personal debt rose almost threefold in the decade from 1997 to $14.4 trillion. This helped to fuel a domestic boom from the mid-1990s, but one that was never going to be sustainable.

Secondly, the long wage squeeze and the growing concentration of income at the top led to record corporate surpluses and an explosion of personal fortunes. Instead of being used to create new wealth via an investment and entrepreneurial boom (as predicted by market theorists), these massive cash surpluses were used to finance a wave of speculative financial activity and asset restructuring. The effect was the upward redistribution of existing wealth and the fueling of the bubbles — in property and business — that eventually brought the global economy to its knees. That inequality is also acting as a profound drag on the prospects of recovery.